You’ve heard of bankruptcy of course, but do you know how people get into situations that mandate a bankruptcy filing? Often financial hardship is caused by events outside of the control of the debtor, such as a major medical emergency, job loss, or divorce. But there are cases in which bankruptcy could have been avoided if the debtor had taken these five proactive steps.
These steps are for those who have steady income but who are not currently keeping careful track of how they spend their money. In these unprecedented times, with political upheaval and the coronavirus pandemic severely affecting our economy, it is more important than ever to get and maintain control of our finances.
Step #1: Maintain an Emergency Fund
If you do not have an emergency fund, start saving now. Conventional wisdom dictates that you should have funds readily available in a savings account in the amount of six to eight months’ of living expenses to pay for any emergencies that arise.
Why? Because of a job loss is your emergency, no state’s unemployment scheme offers full income replacement, and you will need to supplement your unemployment benefits with your savings to maintain your current lifestyle while you look for another job. If you don’t have savings and rely on credit cards to live, those balances grow quickly, and that is a sure path to bankruptcy.
If the emergency is an unexpected considerable expense, you use your credit cards to pay for it, and you pay that debt off over time, you are paying 14%, 21%, or even 26% on that debt. The interest will accrue at an alarming rate if you don’t pay the balance off immediately or quickly. Then what if your hours are cut or you lose your job and you can’t make those monthly payments? This is another sure path to bankruptcy.
Examples of How Revolving Debt Balloons Out of Control
Let’s say that you have a credit card with a 12% interest rate. You think that’s a pretty reasonable rate of interest, and you are right, considering how much you could be charged. But even at 12%, revolving debt balloons out of control quickly.
Let’s also say that your car’s engine seized because a coolant hose blew and you did not stop the car in time. That’s a big repair, but you are not worried about paying for it because you have this credit card. The mechanic tells you that she’ll need your car for two weeks to do the work, so you have to get a rental car in the meantime. Again, you are not worried – you will just put it on that same credit card.
The mechanic’s bill is $6450 in parts and labor, and your rental car bill including all those fees they charge comes to $980 ($70 x 14 days). The total cost for this emergency is $7,430.
You charge this to your credit card, thinking, I’ll throw as much as I can at this every month. You resolve to pay $350 a month towards this debt, which is a stretch but you feel you need to do it to pay this down as quickly as possible. Despite your belt-tightening, it will take you 24 months to pay this debt off – that’s right, two years of sacrifice! – and you will have paid $963.42 in interest over that time.
$963.42. That’s a large sum to have to pay to borrow $7430 for just two years! And what about your lifestyle for those two years? Not ideal, considering how hard you work to achieve the lifestyle you want.
Here’s another scenario, one that is much more common. Let’s say you can only afford to pay the minimum monthly payment, which is $160. In that case, it will take you 63 months, or five years and three months, to pay that debt off. And when you do pay it off, you will have paid the credit card company $2,609.15 in interest. That’s over one-third of the original amount you charged.
Wouldn’t you rather use your own money, sitting in a savings account accruing interest until you need it, to pay for emergencies than pay this exorbitant interest? Using a credit card for emergencies makes you a slave of your credit card lender!
How Emergency Savings Works For You
Both of these high-interest scenarios could have been ameliorated or avoided entirely if you had 6-8 months’ worth of savings available, or you had at least started to save.
Let’s say that for the past five years you put away that $160 month into savings at 0.25% interest. The same car emergency arises, costing you $7,430. You have accrued $9,823 in savings thanks to your small monthly contributions and compound interest. You pay the car repair and car rental in cash, and still, have $2393 in your savings account. You resume making your monthly $160 payments to yourself and start building up your emergency savings again.
Even if you had only been saving that same $160 a month for two years, you would have $4,010 in your savings account. You would have been able to pay for over half the emergency expense and only charge the other $3420. Even if you could only afford to put the minimum $160 a month toward this debt, you would only pay $441 in interest and when the debt was paid in two years, you could resume making that same payment to your emergency savings.
Wouldn’t you rather pay yourself than the credit card lender? Put your money to work for you and no one else by saving for emergencies, rather than charging them.
Use Credit Cards Wisely
This is not to say that you should not use credit cards at all. On the contrary, it is important to use credit cards wisely, to establish your good credit and boost your credit score. Get a card that gives you cashback or points or airline miles, and use it for expenses you would and could have paid for in cash, such as fuel for your car, groceries, or drycleaning. Strive to pay your card off every month to avoid interest charges.
Step #2: Pay All Bills In Full and On Time
This is an absolute must. By paying all of your monthly bills in full and on time, your creditors will report that you are paying accounts “as agreed.” If you do this and do not have a high balance on your credit card, you will have a high credit score.
Why should you be concerned about your credit score? Those with higher credit scores can borrow money, for example, get a mortgage or a car loan, at a more favorable rate of interest than those who have lower credit scores.
For example, let’s say you want to purchase a new car for $25,000. Your friend Betty wants to buy a car for $25,000. You have a credit score of 665, and Betty has a credit score of 695. Neither of you is putting money down on this car – you are financing the whole amount.
Betty will be offered a five-year loan at 4.5%, and her monthly payment will be $466.08; you will be offered a five-year loan at 6.5% and your monthly payment will be $489.15.
A difference of $23 a month does not seem like much, but it adds up over five years. When Betty pays off her car, she will have paid $27,964.80 and $2,964 in interest. When you pay off your car, you will have paid $29,349 and $4,349 in interest.
With only a 30 point difference in your credit scores, Betty is a prime borrower and therefore paid $1,385 less in interest than you, a non-prime borrower, for a car at the same price. Think about what you could have done with an extra $1,385!
Mind the factors that most affect your credit score – keeping current with your monthly payments, and not allowing your debt-to-income ratio to get too high by having high credit card balances.
Step #3: Live Within Your Means
Of course, you are paying into your employer’s 401(k) – if not begin immediately, especially if your employer offers a matching contribution! And you are saving for your emergency fund. You must learn to live on the remainder of your income.
Write down, by hand, all of your monthly expenses. These may include:
- Rent or Mortgage;
- Renters or Homeowners Insurance;
- Utilities (electric, gas, propane, oil, water/sewer)
- Cable and Internet
- Cell Phone
- Home Maintenance
- Car Payment
- Car Repairs
- Car Insurance and Registration
- Commuting Costs (tolls, fuel)
- Personal Care
- Student Loans
- Holidays and Gifts
- Pet Expenses
- Tithing to your Religious Institution
Then consult your bank account and determine what you spend on each in a month. Add it all up and compare that number with your income, after you have subtracted what you are saving for retirement and your emergency fund.
If your income falls short of covering your expenses, you are living beyond your means and need to find a way to cut back. Can you turn the heat down and wear a sweater? Can you be more diligent about turning lights off when you leave a room? Can you take shorter showers? Can you combine errands into one trip to save on fuel? Can you go out to eat twice a week instead of three times?
It will be up to you to find a few small ways to save that will add up and allow you to live comfortably within your means. No amount of indulgent over-spending will satisfy you the way the peace of mind you get from having enough money for now, for emergencies, and for retirement will.
About the Author
Veronica Baxter is a legal assistant and blogger living and working in the great city of Philadelphia. She frequently works with David M. Offen, Esq., a busy Philadelphia bankruptcy lawyer.